In “Activism,” a paper soon to be published by International Finance and already posted at the Council on Foreign Relations, Alan Greenspan delves into the consequences of the recent surge of what he describes as “government activism, as represented by the 2009 US$814 billion programme of fiscal stimulus, housing and motor vehicle subsidies and innumerable regulatory interventions.” Of course, this recent period of extraordinary government interventions has been commented on before. Gillian Tett in a Financial Times article called it the Ad Hoc Age. I called it the Great Deviation because it represents a major deviation from less interventionist or rules-based policies in the 1980s and 1990s. Noting that the current surge is one turn in a longer term cycle, Amity Shlaes argues in a Bloomberg column that we should speed up the cycle and get back to less intervention sooner.
But Alan Greenspan goes further by concentrating on the task of explaining and empirically estimating the costs of this intervention on the economy. “Much intervention turns out to hobble markets rather than enhancing them,” he explains, adding that “unpredictable discretionary government intervention scrambles the prospective underlying supply–demand balance.” More specifically he argues that government-induced uncertainty causes businesses to increase their liquid investments (bank deposits, government bonds, etc.) at the expense of illiquid investments (business fixed investment in structures and equipment). To test the theory he looks at the ratio of business fixed investment to the flow of internal funds which non-financial corporate businesses have available each quarter. That ratio is at historically low levels now which he attributes in large part to the increased activism.
Crowding Out Investment
Of course it’s hard to find a good quantitative measure of activism. Greenspan focuses on the cyclically adjusted budget deficit as a ratio to GDP. Because this measure does not include the “innumerable regulatory interventions” nor the monetary policy interventions not discussed in the paper, it is a downward biased metric of the recent surge in interventions. Nevertheless, he finds a large and significant negative effect of this variable: a one percentage point increase in the deficit as a share of GDP, due say to Keynesian stimulus programs, reduces the ratio of business fixed investment to internal funds by 3.3 percent after controlling for capacity in the nonfinancial corporate sector. (If you look at the regressions in the paper you will find logarithmic transformations of these ratios but they are very close to linear over the relevant range). This crowding out is one reason why he argues that “The recent pervasive macro-stimulus programs exhibit the practical shortfalls of massive intervention.”
The rest of the decline in investment he attributes to other aspects of the activism, concluding that “a minimum of half the post-crisis shortfall in capital investment, and possibly as much as three quarters, can be explained by the shock of vastly greater government-created uncertainties embedded in the competitive, regulatory and financial environments”
Relevant to the Recent Debate over the House Budget Proposals
The study is also relevant to the discussion over whether the new proposals by the House of Representatives to reduce government spending will ‘crowd in” private investment and thereby stimulate employment. Greenspan’s regression results (eg. Exhibit #5 in the paper) imply that reducing the cyclically-adjusted deficit through reduced spending will crowd in private investment as firms allocate a larger fraction of their cash flow to new investment. The estimated effect on investment is virtually immediate occurring within one quarter. I found it interesting that the size of the investment effect (as a share of GDP) is very close to the model simulations reported by Cogan, Cwik, Taylor and Wieland (see Figure 3 of that paper) using a modern “new Keynesian model.” The positive impacts on investment will be even larger as they are viewed as part of a credible longer term plan to reduce the deficit.